Stake Your Declare: Taxpayers Declare Cryptocurrency Creation Is Like Cake Baking And Not Taxable | Eversheds Sutherland (US) LLP

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  Stake Your Claim: Taxpayers Claim Cryptocurrency Creation Is Like Cake Baking And Not Taxable |  Eversheds Sutherland (US) LLP

In a complaint filed in the U.S. District Court on May 26, 2021, a couple seeks a refund of taxes they paid on cryptocurrency tokens created by their husband, claiming that applicable law does not allow any wealth created to be treated as taxable income . They argue that instead, an eventual sale or exchange of such tokens is the activity that leads to the chargeable event.1 The taxpayers argument challenges one of the fundamental guiding principles the IRS has put forward regarding cryptocurrencies for seven years. In the 2014-21 Notice (the Notice), the IRS first provided guidance to taxpayers regarding cryptocurrency.2 Although relatively brief in terms of analysis and content, the Notice provided that cryptocurrency should be used for U.S. federal income tax purposes should be treated as property, with general tax principles, including, for example, that tokens received in exchange for mining are income for the recipient when received. In the lawsuit, the taxpayers allege that they did not receive the tokens at issue as compensation, but created them, like a baker making a cake, and that they should not be taxed immediately when new property is created. While this case, like many implied cryptocurrencies, is very factual and requires a complex understanding of the relevant technologies, it will be interesting to see whether the court slices up a narrow, application-limited decision or serves the whole pie and income realization in the Context of cryptocurrency creation. In any event, a ruling in favor of taxpayers would be more than food for thought – it would be a rejection of the longstanding IRS cryptocurrency policy with the potential for far-reaching ramifications.

Overview of the claim

At the center of this claim is an understanding of how blockchain technologies work and how cryptocurrencies are created. The disputed units of the cryptocurrency in this case are Tezos tokens. Cryptocurrencies, such as Tezos coins, use cryptography to secure transactions that are digitally recorded on a distributed ledger such as a blockchain. A blockchain is a specific cryptographic data structure that transmits data in blocks that are linked together in a chain. There are two main methods for users to validate cryptocurrency transactions: mining and staking. Mining is the process by which computers create new blocks in the chain, validate the cryptocurrency transactions, and manage the distributed ledger. Miners are rewarded for the “validation service” by issuing new cryptocurrency units. When staking, the validator pledges some of its tokens in order to prove the validity of the transactions reported in the respective block in the chain. Both methods, mining and staking, can result in the miners and validators receiving newly created cryptocurrency tokens.

The taxpayer in this case claims that his staking company resulted in the creation of new blocks on the Tezos public blockchain, which in turn resulted in the creation of new Tezos coins. In addition, the taxpayer claims that no person within the meaning of the Internal Revenue Code paid him the newly created Tezos coins. Since the taxpayer has not sold or traded any of the new Tezos coins received as a result of his staking business, the taxpayer claims that he has not yet made any income. The taxpayer compares his situation to that of a “baker who bakes a cake with ingredients and an oven, or a writer who writes a book with Microsoft Word and a computer”. The taxpayer believes that the new Tezos coins he created as a result of his staking business should be treated in a similar way to such other created assets and therefore should not start earning any income until he uses the newly created one Selling or exchanging property.

Evershed’s Sutherland perspective

Similar to most transactions involving cryptocurrencies, and possibly due to the lack of comprehensive specific guidance on this new technology that the IRS has so far provided, in this case taxpayers are trying to rely on outdated, albeit reputable, jurisprudence, to apply longstanding law tax principles to this new technology. Taxpayers rely on the rulings of the Supreme Court in Eisner v Macomber3 and Commissioner v Glenshaw Glass4 for the theses that income must include an “inflow” and that income includes a “clearly realized” increase in wealth to be treated as income. Taxpayers claim that these principles must be interpreted in their favor, eg that property created by the taxpayer “goes out” and not “goes in” and property created is not “realized” wealth.

Depending on the perspective of cryptocurrency technology, tokens that result from “validation services” can be viewed as being created by the validator or issued to the validator. As noted by the taxpayer, the question arises of “who” would issue such new coins and whether “who” is a person under current tax law. It will be interesting to see how the court addresses these fundamental questions about the nature of crypto and what traditional activities the parties engaging in crypto activities are more analogous to for tax purposes, service providers or new property creators. In the latter case, the IRS may need to review their entire prescription book for the tax treatment of this technology.

It should be noted that currently some cryptocurrency exchanges, including Coinbase, are treating newly created cryptocurrencies received in connection with staking activities as income for the taxpayer, in line with the IRS guidelines in the notice. Coinbase specifically addresses staking activities on its user help website, stating that US customers who are subject to US tax returns must “report their staking reward income” and that Coinbase should all US customers who earn more Submitting a 1099-MISC Form will add $ 600 in staking rewards.

Thus, in addition to taxpayers acting as miners and validators, the outcome of this case could also have an impact on US tax reporting requirements of cryptocurrency exchanges, prompting the IRS to issue new and different guidance on the matter across the board.

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1. Joshua Jarrett et ux. v USA, No. 3: 21-cv-00419 (MD Tenn. 2021) (May 26, 2021).

2. 2014-16 IRB 938 (March 25, 2014).

3,252 U.S. 189 (1920).

4,348 U.S. 426 (1955).

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